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1 Overview of the discussion What “Street” economists do How we do economics differently

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2 Economics on Wall Street Non-financial business Only limited interest in macroeconomic trends More interest in microeconomics Financial business Very interested in macroeconomics All asset classes affected Extreme case: macro hedge funds

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3 Macroeconomics and asset prices In general, any asset price is the product of: an expected future payoff (for example, a coupon or a dividend) and how that future payoff is valued in today’s terms (that is, the interest rate used for discounting). Macroeconomic forces influence both the asset’s payoff and the discounting factor, or interest rate.

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4 Interest rates and macroeconomics Taylor rule and target federal funds rate Simplest asset: Treasury security (no risk*, no embedded options). Payoff is simple, what’s interesting is the discounting: the interest rate. Long term interest rates = expected average short term interest rate + term premium. Shortest-term interest rate set by the central bank. Central bank sets short term rate following news on growth and inflation. Thus, Treasury rates are expectations of central bank action on growth and inflation. Very long term rate (30 years) the influence of current economic developments is limited. Shorter duration (2 years) more influenced by current economy. Taylor rule: rough formula that describes how a central bank should set short-term interest rates. From the rule, short-term rates rise with inflation and fall with the unemployment gap.

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7 Currencies and macroeconomics Two broad frameworks for thinking about currencies and macroeconomics. PPP (purchasing power parity): useful in the long run, or thinking about currencies in high-inflation countries. Interest rate parity: probably more useful in shorter-run analysis or with pairs of low inflation countries. In interest rate parity framework, all of the earlier cited impacts of macroeconomics on interest rates apply, times two. Dollar and EASI Note: no framework works very well, currency behavior remains somewhat of a mystery.

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8 A simple macroeconomic framework The main variables of interest: Output growth, or GDP growth, or just simply growth Inflation Interest rates The main relations: Output growth is a function of interest rates, plus “other stuff” (changes in tax policy, natural disasters, etc.) Inflation is a function of output growth, relative to potential output growth, plus “other stuff” (import prices, energy prices, etc) The interest rate set by the Fed is a function of inflation and output growth and “other stuff” (credibility, financial crises, etc)

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10 Data watching growth GDP, the central focus in assessing growth, is defined as the market value of all final goods and services produced in a country in a given period. Three ways of measuring GDP which are equivalent (in principle): The expenditure measure. Output is measured by the type of final purchase: consumption, investment, government spending and net exports. This is the preferred measure in the most countries. The industry output measure. The sum of value added across industries. This is the preferred measure in fewer countries. The income measure. The costs incurred and income earned in producing output; often divided into labor compensation, several components of capital income, and some other small technical categories. This is a subsidiary measure of output in most countries.

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13 Building up expenditure-based GDP in the US Timely indicators help to estimate how GDP growth is tracking within each quarter. Recent example of this in practice (from JPMorgan’s US economic commentary): (January 26) …orders and shipments for nondefense capital goods (ex- aircraft) both increased 2.9%...Today's report leaves us on track for a 3.0% or 3.1% print on GDP in tomorrow's first look at Q4 growth, and the strength in the capital goods numbers late last quarter sets up a relatively firm trajectory for capital equipment spending heading into Q1.… (November 15) …Retail sales were solid in October, increasing 0.5%... We don't have much other hard data for the quarter yet (particularly for imports and inventories, which could be swing factors) but our best estimate is now that overall GDP growth in Q4 is also tracking close to 3.0% (our previous estimate was 2.5%).

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16 Inflation: some fundamentals Inflation: a continued rise in the overall price level. Milton Friedman: inflation is always and everywhere a monetary phenomenon. In the US, however, the link between inflation and measure of monetary aggregates broke down decades ago. Inflation and the money supply

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17 Inflation: some fundamentals After money “broke down” US economists returned to analyzing resource utilization as the main driver of the change in inflation rates. Two approaches: Traditional Phillips curve. Given a natural rate of unemployment, or NAIRU, denoted u*, inflation pressures will be determined by where the actual unemployment rate, u, is in relation to NAIRU. If u>u*, inflation pressures are easing. If u<u*, inflation pressures are building. Output gap-based Phillips curve. Given the full-employment potential output of the economy, denoted y*, inflation pressures will be determined by where the actual output, y, is in relation to potential. If y y*, (a positive output gap) inflation pressures are building.

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18 Inflation: some fundamentals Money replaced with “gaps-based” approach: inflation pressure determined by how far economy operating from its full-capacity potential. There are two problems with practical implementation: NAIRU and potential output are unobserved. The estimates we have are often revised after several years. In the short-run, other factors such as supply shocks can influence inflation as well as distort the signal of true, underlying inflation NAIRU gapOutput gap

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